AGEFI Luxembourg - mai 2025

AGEFI Luxembourg 38 Mai 2025 Droit / Emploi O n 17April 2025, the Luxembourg administrativeCourt (Cour administrative, 17 avril 2025, n° 50602C) (the “AdministrativeCourt” or the “Court”)was calledupon to take positionon the qualificationof interest- free loanpayables (IFLs) granted to the taxpayer by its indirect sharehold- er for direct tax purposes. Summary of the case In October 2014, the taxpayer acquired two shareholdings and planned to establish a branch in Malaysia to which the participations would be allocated. In August 2015, the taxpayer requested a tax ruling from the Luxembourg tax authorities ( LTA ) to confirm that the Malaysian branch would be recognized as a permanent establishment ( PE ) and that the exemption of these participations for Luxembourg direct tax purposes would apply. However, the LTA denied the request, stating that the structure lacked economic substance and would fall under §6 of the Luxembourg Tax Adjustment Law ( Steueranpassungsgesetz , “ StAnpG ”). In August 2020, the LTA challenged the taxpayer’s 2015taxreturn,disagreeingontwomainaspectsrelat- ed to the netwealth tax ( NWT ) liability for 2016: - The IFLs financing the participations at the level of the taxpayer should be reclassified as hidden capital contributions, and thus, should not be deductible for netwealth tax purposes. - The Malaysian branch should not be considered a PE (1) , and consequently the participations attributed toitshouldbereintegratedintheassetsofthetaxpayer when computing its 2016 unitaryvalue. The taxpayer filed an administrative claim with the Director of the LTA in January 2021. However, the Director upheld the LTA’s position. As a result, the case was further escalated to the Luxembourg AdministrativeTribunal( theTribunal ),whichreject- ed the taxpayer’s claim (2) . The taxpayer then lodged an appealwith theAdministrativeCourt. Decision of theCourt In the case at stake, the Administrative Court sided with the Tribunal’s analysis, and as a result the out- come remained unchanged for the taxpayer. Both aforementioned points of disagreement were addressed indetail by theCourt, namely: - The tax qualificationof the IFLs; and - The recognitionof the existence of aPE inMalaysia. The qualificationof the IFL for direct tax purposes Thejudgesstartedtheirreasoningbyrejectingthetax- payer’sattempttoapplyarticle40oftheLuxembourg income tax law( LITL ) (3) to the case.Article 40 LITL is generallypresentedassettingtheprincipleaccording to which tax would normally follow accounting, except where the LITL specifically provides other- wise. For the Court, article 40 LITL does not concern the qualification of a financial instrument, but only the valuation of assets and liabilities for the purposes of the taxbalance sheet and therefore cannot apply to justify a debt qualificationof IFLs. In the judges’ view, the sameapplies for §11StAnpG that does not in itself concern the classification of a financial instrument froma tax perspective but con- stitutes a practical applicationof the principle of eco- nomicappreciation(i.e.theso-called“substanceover formprinciple”) that should come into play in prac- tice in the caseat stake. In that regard, the judgesout- lined that in accordance with settled case law, the administrative jurisdictions should be entitled to interprettransactionsbasedoneconomiccriteriaand are therefore able todisregard the legal characteriza- tions put in place when these do not reflect the par- ties’ true intentions. In this context, the judges referred to the parliamen- tary comment under article 114 of the draft LITL (Bill of law 571) that became article 97 LITL. Such parlia- mentarycommentnotablyprovidesthataloangrant- ed by shareholders to a companymay, in certain cir- cumstances, constitute a hidden capital contribution andbetreatedasequity.Thiswouldbethecasewhere the analysis of the characteristics of the loan and the circumstancesunderwhichitwasgrantedrevealthat, fromaneconomicperspective, it shouldbeassimilat- edtoaparticipationintheequityofthecompanycon- cerned, andwhere the context makes it clear that the loanwas chosen solely for tax-driven reasons. In essence, in application of both the parliamentary commentaries and previous case law (4) rendered by the administrative jurisdictions, the judges recalled that suchanalysis shouldprimarily focus on twodis- tinct sets of elements: -Reviewofthetermsandconditionsoftheagreement, inparticular its interest rate and the repayment terms of the funds lent; and - Examination of the facts and circumstances sur- roundingthetransactionandthegrantingoftheIFLs. Having laid down these principles, the AdministrativeCourt then turned to themainpoints of disagreement between the applicant and the LTA. The allocation of the funds The judges fully endorsed the Tribunal’s view that the IFLs were intended to finance participations that should qualify as fixed assets (i.e. long-term assets). Several case-specific elements supported this conclu- sion – providedbelowfor reference: - The IFLs were ultimately used, through the partici- pations acquired, tofinance a gas pipeline project; - The participations were recorded as non-current assets in the taxpayer’s balance sheet, in contrast to currents assetswhichwere identified as short-term; - The acquisition of the participationswas contingent on certain conditions, including approval from gov- ernment authorities, which suggests that the project was intended to be long-term; - The entities inwhich the taxpayer acquiredapartic- ipationwere not listed companies; - The taxpayer didnot hold any other assets andwas notengagedinanyactivitiesotherthanacquiringand managing those participations; - The taxpayer had a “significant influence” on the entities inwhich it held a participation (based on the readings of notes to the annual accounts); and - The legal denomination of the appellant and those of the companies inwhich it heldparticipationswere similar (showing the intention to forma group). Finally, although the taxpayer argued that long-term assets should be financed through long-term instru- ments — which was allegedly not the case here, as the IFLs at issue had only a 10-year maturity — the Court ruled that such strict correlation should not be required. Furthermore, it emphasized that the trans- actionshouldbeanalyzedglobally,notingthat,inthe case at hand, the group’s strategy had consistently beentofinancethetaxpayerthroughsuccessiveshort- term loans, which, in substance, was equivalent to providing financing to the taxpayer for a maturity longer than 10 years. The disproportionbetween the borrowed funds and the tax- payer’s equity TheAdministrative Court further confirmed the dis- proportion between the taxpayer’s borrowed funds and equityhighlightedby the Tribunal. -While the taxpayer tried to challenge the Tribunal’s reasoning, arguing that the relevant moment for assessing the debt-to-equity ratio shouldbe the point in time where the funds were made available (as opposed to when the participations were acquired), theCourt found the Tribunal’s choice reasonable. - Inaddition, the appellant’s argument that, basedon marketpractice,participationscouldbefinanced85% bydebtand15%byequity(85:15ratio)wasdismissed by the judges according to whom this practice was neither legally bindingnor sufficiently evidenced. -Furthermore,theCourtrejectedtheappellant’sargu- ment that the re-characterizationof the IFLs as equity shouldbelimitedtothepartexceedingtheamountof the debt considered to be at arm’s length. For the judge, a partial re-characterization of the IFLs is not possible. According to the Court’s decision, financial instrumentsmustbefullycharacterizedeitherasdebt or hiddencapital contributions, though the judgedid not fully explain or justify the reasoning leading to this conclusion. Finally, the risk exclusively borne by the lender was also seen as a strong indication that the financing shouldnot be treated as genuine debt. The absence of guarantees The Court rejected the appellant’s arguments con- cerning the absence of guarantees on the IFLs as the latter failed todemonstrate the effective impact of the absence of a limited recourse clause provision in the contract. Indeed, the Court observed, based on the management report and the taxpayer’s annual accounts, that repayment was subject to available funds. The taxpayer’s claim that a pledge over its shares was neither possible nor relevantbecausethelenderwasitsshare- holder was dismissed as well. For the Court,thelenderwasanindirectshare- holder(andnotadirectone),andthere- fore a pledge was possible. Moreover, for theAdministrative Court, the tax- payer did not substantiate why no otherformofsecuritycouldhavebeen considered. The absence of any guarantees was therefore upheldandseenasanaddition- alindicatorthattheIFLsshould be requalified as hidden capital contributions. Other criteria taken into account by the Court The Administrative Court reviewed the appellant’s argument that other criteria for the characterization oftheIFLshadbeendismissedarbitrarilyandwithout justification by the Tribunal. However, theCourt fol- lowed the reasoningof theTribunal,mentioning that these criteria had been taken into consideration, but thesituationshouldbeassessedglobally(andamajor- ity of debt features (terms and conditions)wouldnot be sufficient in the case at stake as the various criteria (terms and conditions as well as economic circum- stances)shouldnotnecessarilybegivenequalweight). The following criteria helped informthis decision: - The absence of anyparticipating interest; - The absence of any participation in the liquidation proceeds; -Theabsenceofthepossibilityofconvertingtheprin- cipal amount into equity; -Theabsenceofthepossibilityofrepayingtheprinci- pal through the issuance of shares; and - The absence of voting or information rights. For the Court, even though these undisputed char- acteristics of the IFLs pointed to a debt qualification for Luxembourg direct tax purposes, the global pic- ture led to an equity characterization. TheCourt fol- lowed the reasoning of the Tribunal and concluded on the re-characterization of the IFLs as equity for direct tax purposes. The existence of a PE TheAdministrativeCourt also agreedwith the con- clusions of both the Director of the LTA and the Tribunal regarding the non-recognition of a PE in Malaysia. BasedonthedoubletaxtreatybetweenLuxembourg and Malysia ( DTT ) which, for the most part, pro- vides a PE definition in line with the Organisation for Economic Co-operation and Development’s ( OECD )Model Convention (5) , the judges reaffirmed that a PEmust be a physical place of business, char- acterized by its fixed and relatively permanent nature. In that sense, even though the judges acknowledgedthatanofficelocationcouldoccasion- ally change, they nonetheless emphasized that an alleged PEmust remain easily identified. Observing that the documentation provided by the taxpayer wasinconsistentinthatregard,thejudgesconsidered thisasaseriousindicationcastingdoubtontheactual existence of the allegedPE. This was further confirmed by other elements, notably: - The intragroup rental contract for the office was signed more than one year after the alleged creation date of the PE and was made retroactively effective. The judges found that such retroactive effectwas not justified in this context; - The transfer pricing study submitted by the appel- lantindicatedthatthetaxpayerwassupposedtopro- vide certain services its branch, which it ultimately never did; - The taxpayer didnot provide any proof evidencing it had actuallypaid for the allegedoffice; -AbankaccountinMalaysiawasonlyopenedseveral years after the formationof the branch; -Themanagerofthebranchcouldnotbeclearlyiden- tified; and - There were inconsistencies in the documents pro- vided by the taxpayer regarding the address of the manager of the branch. Finally,thejudgessustainedthatwhilemanagingtwo participationsshouldnotinitselfrequirealargenum- ber of branch staff, some real management activity should still take place. However, no evidence of such activity being performed in Malaysia was provided by the taxpayer. In light of the above elements, the Administrative Court concluded that no PE could be recognized in Malaysia and therefore confirmed the reintegration of the participations to the taxpayer in Luxembourg for the computationof its unitaryvalue. Takeaways Thisdecisionisofparticularsignificanceasitaddress- estwocomplexdirecttaxissuesthathaveincreasingly been the subject of scrutiny and challenges for Luxembourg taxpayers in recent years – the qualifi- cation of loans as either a debt or an equity instru- ment, and the documentation to evidence the exis- tence of a PE abroad. Regarding the second element (i.e. the PE qualification), the decision is not surpris- ing, even though it did relate to a tax year in which the new provisions for the recognition of a foreign PE under domestic tax lawhad not yet been imple- mented. In linewithpreviousdecisionsof theCourt, it clearly emphasizes the critical importance of doc- umentation evidencing a PE’s existence. The LTA are generally cautious when it comes to allowing the relocation of assets or income abroad. Consequently,anydocumentspresentedtosubstan- tiate the existence of a fixedplace of businesswill be subject to rigorous scrutiny. It seems that ultimately, in this case, it was the inconsistencies and gaps in the documentation provided by the taxpayer that led to the rejection of its claim. However,thedecisionrenderedbytheCourtismore interesting on the first of the two points, i.e. the re- characterization of the IFLs. The decision of 17April 2025 is not surprising as it is in line with the Tribunal’s findings, but it was also in line with sev- eral other decisions rendered recently on the same topic (6) . The approach taken by the administrative jurisdictions is therefore consistent and, in the case at hand, the outcomewas to be expected. With respect to the assessment whether an instru- ment should be considered as debt or equity, this decision illustrates well the importance given to the substance over form principle, which at the end of the day allows the LTA and the judges to disregard legalqualificationswhentheycometotheconclusion that such instruments were primarily employed for tax-drivenreasons.Furthermore,itshouldbeempha- sized that, despite a list of criteria (terms and condi- tionsaswellaseconomiccircumstances)beingestab- lished through various pieces of case law that have enabledtheclassificationofinstrumentsaseitherdebt or as equity, the judges remain at liberty, on a case- by-case basis, to decide whether they should be placed on equal footing. In the case at hand, several elementswerethereforeconsideredirrelevantforthe purpose of the assessment. Thatbeingsaid,thetopicsexploredinthedecisionof 17April2025remaintrickyastheyareheavilydepen- dent on the facts andcircumstances surrounding the situationbeingchallenged.Thedecisionclearlyillus- trates this fact. Indeed, a comparison between this decision and anotherAdministrative Court decision dated 23 November 2023 (7) shows that, dealing with financial instruments with quite similar characteris- tics, the Court took opposite decisions (debt charac- terizationin2023andequitycharacterizationin2025) without contradicting itself, simply on the grounds thatthetwocaseshavedifferencesintheirapplicable factsandcircumstances.Thisshowsthatbetweenthe two key elements we mentioned before, i.e. review of the terms and conditions of the agreement on the one hand, and examination of the facts and circum- stancessurroundingthetransactionandthegranting of the financial instrument on the other, the second one appears to be decisive. Finally,itshouldbenotedthateventhoughtheCourt concluded in the case at stake that further to the re- characterization of the IFLs into equity for direct tax purposes and the absence of a PE in Malaysia, the question of the existence of an abuse of law was no longer relevant, this remains an important potential argument for the LTA that taxpayers should keep in mindwhen establishing their activities. Emilien LEBAS, Partner, Head of International Tax, Tax controversy & dispute resolution leader Valentine PLATEAU, Manager, International Tax, KPMG Luxembourg 1)We understand that the taxpayer attempted to assert the exis- tence of a permanent establishment in Malaysia, despite being deniedataxrulingonthismatter. 2)Tribunaladm.,8May2024,n°47267. 3) Unofficial English translation by the authors of Article 40 (1) LITL:“ (1)Wheretheregulationsgoverningvaluationfortaxpurposes donotrequirevaluationataspecificamount,thevaluestobeusedinthe tax balance sheet must be those of the commercial balance sheet, or as closeaspossibletothesevalueswithinthelimitsoftheapplicablerequire- ments,dependingonwhetherornotthecommercialbalancesheetvalues meetthesamerequirements.” 4) Cour adm., 26 July 2017, n° 38357C ; Cour adm., 31 March 2022,n°46131Cet46132C. 5) The minor differences between the DTT and the OECD’s Model Convention were deemed not relevant by the judges in the case under review and will therefore not be detailed in the presentarticle. 6)Onthesametopic,pleaserefertoourotherarticles: - E. Lebas and V. Plateau, “ Administrative court judgement on tax rulingandpermanentestablishment ”,AGEFILuxembourg,October 2023,Page8. -E.LebasandV.Plateau,“ Administrativecourtofappealdecisionon the economic appreciation ”, AGEFI Luxembourg, December 2024, Page39. 7)Couradm.,23November2023,n°48125C. Administrative Court - Judgment on requalification of interest-free loan as hidden capital contributions